Redwheel: Why emerging markets may have reached an inflexion point

For professional investors and advisers only

By the Redwheel Emerging & Frontier Markets team

For the better part of the past decade, emerging markets have been out of favour with investors. But the current sell-off is approaching an end just as global demand for ‘transition’ metals takes off. It means emerging markets may have reached a turning point, and it’s up to savvy investors to take advantage.

Key takeaways

• Over the last decade, emerging economies have demonstrated resilience, tight monetary policy and GDP growth.
• Valuations are attractive due to foreign investor capital outflows.
• The green energy transition is expected to drive future emerging market growth.

Emerging market indices have performed poorly over the past 10 years, acknowledges Redwheel Co-Head of Emerging and Frontier Markets, James Johnstone.

Speaking in Sydney in November 2022, Johnstone said that growth in the sector began to stall towards the end of the 2010s – largely as a result of fiscal tightening in China and recessionary conditions in Brazil. For many investors, the slowdown prompted an exit from emerging markets.

But the decade-long sell-off has led to attractive valuations at a time when a commodity super-cycle could pave the way for outperformance, Johnstone said.

Transition metals and emerging markets

A major theme in recent years is decarbonisation. Major economies are beginning to wean themselves off fossil fuels and are looking for new ways to curb emissions, with many aiming to achieve net zero between 2030 and 2050.

By current estimates, US$56 trillion in incremental infrastructure investment is needed to meet net zero by 2050. This implies an average investment of US$1.9 trillion annually.

Central to achieving these emission targets will be transitioning our existing energy infrastructure to cleaner fuel sources, Johnstone said, adding that this places many emerging market nations in an enviable position.

That’s because the transition away from fossil fuels is likely to be metal intensive, Johnstone said. Replacing existing fuel sources with renewable electricity and manufacturing batteries to store this power will require large volumes of metals such as copper, lithium and rare earth elements.

“Now the interesting thing is where are we going to find those metals? There's a little bit in Australia and there's a little bit in Canada, but the last bulk of all the new metal discoveries we're going to need to make are going to be in Africa or in South America,” Johnstone said.

Johnstone said that demand for these metals could begin to outpace supply, creating bottlenecks and price hikes – all to the benefit of producing nations. The scarcity of these resources also places significant power into the hands of local governments to raise tax revenues, Johnstone said.

Peru and Chile, collectively producing 35% of global copper, provide a good example of this.

“Neither [Peru nor Chile] are particularly comfortable places to put more money. It costs billions of dollars to invest there,” he said.

“[But if you’re talking to] Glencore or Goldfield – who are commissioning to put US$2 billion, US$3 billion or US$4 billion into each hole in the ground in Chile - they have to sit down with President Boric and say, ‘what's my royalty rate?’, ‘what's the taxation rate?’ And the threat of expropriation is very high.”

While this does present risks to producers, Johnstone noted that these risks have been priced in.

Attractive valuations versus developed markets

The demand for metals is expected to support the growth of emerging markets and widen the real GDP growth differential with western markets. This helps forward price-to-earning (P/E) ratios for the sector look relatively attractive, Johnstone said.

In part, Johnstone said, this is attributable to the commitment of emerging nations to maintain tight monetary policy over the past decade. These economies have largely avoided using unconventional policies (such as quantitative easing) which western nations used to stimulate their economies following the 2008 global financial crisis. And they raised rates before developed economies – and remain ahead of the curve.  

“Emerging markets have been incredibly orthodox in monetary policy because they learned their lesson and they don't want to give up the central bank credibility that they've taken 20 years to build,” Johnstone said.

“They hiked fast and they hiked early and they should be able to have the ability to cut. And what does this all mean? It just means they're incredibly cheap.”

So as developed economies struggle with soaring inflation and interest rates, past experience with inflation and monetary constraint have made emerging market economies resilient.

Attractive emerging markets forward price to earning ratios

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Johnstone said emerging markets have fallen to valuation levels not seen since 2008 while earnings continue to climb, generating attractive forward P/E ratios.

Yet despite attractive valuations, Johnstone noted that international capital flows into emerging markets are close to record lows. Since the early 1990s, Johnstone said, buying emerging markets at times when most investors are selling has proven to be a successful strategy.

Investor capital has exited emerging markets creating contrarian opportunities

*Korea, Taiwan, India, Brazil, Mexico, South Africa, Thailand, Indonesia, Philippines, Malaysia, Turkey. Source: CLSA, National Stock Exchanges, WFE as at 20 October 2022. The forecasts and estimates are based upon subjective assumptions about circumstances and events that may not yet have taken place and may never do so. The information shown above is for illustrative purposes only and is not intended to be, and should not be, interpreted as recommendations or advice.

“If I'd stood here in 2002 and told you to buy emerging markets, you would've thought I was mad,” he said. “Emerging markets had been through an incredibly difficult crisis. The Indonesian economy had collapsed in 1997. The rupee went from 2,000 to the US dollar to 18,000 to the US dollar in the space of six months. The Thai baht collapsed. The Korean won collapsed.

“But emerging markets did actually exactly what we told you they were going to do. Emerging market GDP grew. The emerging market growth story worked. The miracle worked. China raised 750 million people out of poverty. The Indonesian GDP has gone from US$200 billion to US$1.1 trillion. India's now a larger economy than the UK.”

With that context in mind, Johnstone said the emerging market selloff could represent a good entry point at attractive valuations for investors.

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Important Information

No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment.

Past performance is not a guide to future results. The prices of investments and income from them may fall as well as rise and an investor’s investment is subject to potential loss, in whole or in part.

Forecasts and estimates are based upon subjective assumptions about circumstances and events that may not yet have taken place and may never do so.

Unless otherwise stated, all opinions in this article are those of the Redwheel Global Emerging and Frontier Markets team as at November 2022.  This article does not constitute investment advice and the information shown is for illustrative purposes only.

The Responsible Entity and issuer of units in CC Redwheel Global Emerging Markets Fund ARSN 630 341 249 and CC Redwheel China Equity Fund ARSN 656 117 421 (the Funds) is Channel Investment Management Limited ACN 163 234 240 AFSL 439007 (CIML). The CC Redwheel Global Emerging Markets Fund invests into Class F Shares in the Redwheel Global Emerging Markets Fund (Underlying Fund) which is a sub-fund of the Redwheel Funds, an open-ended collective investment company domiciled in Luxembourg. The Investment Manager of the Underlying Fund is RWC Asset Advisors (US) LLC (Redwheel). The information above is provided by Redwheel. To the extent permitted, all liability is disclaimed for any loss or damage incurred by any person relying on the information in this email. While every effort has been made to verify the data in the attached report, neither CIML nor Redwheel warrant the accuracy, reliability or completeness of the information nor do they guarantee the repayment of capital, the performance of the Funds or any particular rate of return. Past performance is not an indicator of future performance. The prices of investments and income from them may fall as well as rise and an investor’s investment is subject to potential loss, in whole or in part. This communication has been prepared for the purposes of providing general information, without taking into account any particular investment objectives, financial situation or needs. The Responsible Entity has issued offer documents for the Funds which contain important information and are available here. An investor should, before making any decision to acquire, or continue to hold an investment in the Funds, read and consider the PDS and any updated information and seek professional advice, having regard to the investor’s objectives, financial situation and needs. A Target Market Determination for the Funds is available here.